China has managed to avoid serious cyclical downturns literally for decades. The world’s second largest economy has seemingly even escaped unscathed from the global financial crisis and the associated temporary collapse in international trade. Economic gravity, however, is catching up with the Chinese growth miracle. The country’s export-led growth model appears to have run its course and it remains to be seen how the country will rebalance towards a more consumption-led model. This is the first of a series of five articles that explores China in more detail.
Figure 1: China Exports of Goods (2000-2013)
Source: Euromonitor International (Economic Observer)
China’s Export-Led Growth Model has Reached its Limits
Over the last three decades China has experienced a remarkable transformation, going from being a poor and largely agricultural economy to becoming the world’s industrial powerhouse. Strong and relentless economic growth was achieved on the back of productive investment, an ample and industrious labour force, relatively low wages and a parabolic rise in exports. In light of this, economists usually refer to China’s economic growth model over the last three decades as investment- or export-driven.
China’s growth strategy proved highly successful but its weaknesses became more evident around the time when the global financial crisis erupted and international trade suffered a sudden collapse. As the global leader in international trade, China is critically dependent on the state of the global economy and foreign demand for its products. With prospects for export growth weakening, Chinese optimists hoped for a seamless transition to a sustainable domestic consumption-led growth model but this has proved much easier said than done, with China still pushing the old model beyond its limits.
As societal stability in China relies heavily on strong economic growth, China’s political leadership could not allow the economy to slip into recession when demand for exports dwindled in the wake of the global crisis. Subdued export demand was to a large extent offset by huge domestic stimulus measures and a credit-driven construction boom. Consequently, over the last few years, China’s economic model seems to have become better characterised as a credit-driven economy or even a bubble economy.
Credit-Driven Investment Can Offer Only Temporary Support
The credit-fuelled investment boom helped to maintain economic growth rates close to pre-crisis levels, dropping only from around 8% to 7% over the 2008-2011 period. The flip side of this was a worrying rise in debt levels, inefficient capital allocation, industrial overcapacity, a housing bubble, the build-up of potentially impaired loans and a clearly overstretched financial system. Export recovery proved temporary as export growth has waned since 2012 amid the sluggish global economic climate. A domestic debt hangover started to weigh down on industrial activity and economic growth weakened quite significantly, once again exposing structural weaknesses in the economy.
In this context, China’s political leadership faces a difficult task of re-orientating the economy towards a more sustainable, consumption-driven model but at the same time dealing with credit and property booms. The task is greatly complicated by the need to maintain sufficient growth momentum. Many economists, as well as China’s political leaders, deem GDP growth of around 7% as necessary to sustain employment and ensure social stability. The problem is that once the political leadership takes serious steps to control inefficient investment and deal with the bubbles, this will immediately weigh down on economic activity, while high economic growth targets will force the leadership to back off from the reform agenda.
A Broad-Based Economic Slowdown and Challenges to Competitiveness
China is currently experiencing a broad-based economic slowdown. In 2013, China’s real GDP grew by 7.7%, close to the lowest rate in 14 years. Gross capital formation was likely the primary driver behind GDP growth. Investment in fixed assets grew at a real rate of 19%, unchanged from the prior year. Growth of investment in residential buildings picked up strongly to 19% (in real terms) amid a renewed rise in housing prices, which rose by 12% in 2013. Consumption growth was relatively steady, with retail sales volume rising by 12%. The share of household consumption in GDP stood at 36% in 2012, which is extremely low by global standards, with a global average of around 60%. It is unlikely that there was any significant increase in 2013, implying no progress towards more consumption-oriented growth. Exports continued to grow at 8%, the same rate as in 2012, but growth was more than twice as slow compared to typical growth in the years prior to the global financial crisis.
In 2013, real per capita income growth of urban households slowed to 7% from 10% in 2012. Consumer price inflation, at a rate of 2.6%, was well within policy makers’ comfortable boundaries, but, notably, food price growth was considerably stronger than headline inflation and stood at 4.7%. Relatively high food price inflation against the backdrop of high income inequality and slowing income growth indicates that a large part of the less well-off population remains vulnerable to price rises. This may also be one of the factors behind rather soft domestic demand.
Wage growth in China, still very rapid in a global context, is moderating. On average, urban salaries grew by an estimated 11% in 2013, following increases of 12% and 14% in 2012 and 2011, respectively. An important driver behind wage growth is gradual increases in the minimum wage as the government is encouraging consumption-led growth and pushing the economy to shift away from low-cost manufacturing, which is polluting and capital-intensive. The downside of these developments is that wage growth is outpacing labour productivity growth, which slipped to 7% in 2013 – the slowest pace in a decade. This is leading to rising real labour costs and a decline in the international competitiveness of Chinese companies. Thus, some multinational companies are starting to seek ways to shift production from China to lower-cost countries such as Vietnam or even bring production back to developed economies. As a further indication of the increasing challenge of remaining competitive, in 2013 China’s real effective exchange rate appreciated at the fastest pace among major economies, by around 8%.
Short-Term Cyclical Indicators also Point to Persistent Economic Weakness
Short-term indicators also point to the further weakening of the Chinese economy. Amid subdued demand growth and industrial overcapacity, producer prices fell by 1.4% year-on-year in December, marking a 22nd consecutive year-on-year decline. Business confidence has been declining since 2011. Similarly, the manufacturing Purchasing Managers’ Index has hovered close to contraction levels for the last two years. Rising unit labour costs on the one hand and rising corporate debt and higher interest rates on the other might squeeze profit margins and lead to cash flow problems. Surveys show that in January employment levels at Chinese manufacturers fell at the fastest rate since March 2009.
As both structural and cyclical factors point to a slowdown in the Chinese economy, Euromonitor International anticipates China’s economy to grow by 7.4% in 2014 and 2015, with growth rates sliding further towards 6% in subsequent years. It must be stressed, however, that given the immense complexity and great opacity of China’s state capitalist system, the true extent of China’s structural problems and imbalances may not be known in advance. Therefore, there is huge uncertainty with regard to a soft or hard landing, but risks to this outlook remain concentrated on the downside. One thing is clear, however. A weakening economy will prompt a policy response, either in the form of serious structural reforms or crisis management measures.